One of the key risks to the stock market is earnings expectations. As recession risk rises, it has been unusual to see forward 12-month EPS estimates continue to rise. The latest update finally shows that earnings expectations are beginning to stall. S&P 500 estimates are flat for the week, up a miniscule 0.01, while small-cap S&P 600 estimates are down over -1% in the week.
Why haven’t stock prices skidded further? Here are some reasons why this cycle is different from others.
Recession fears overdone
Here is the bull case. Recession fears are overdone and a slowdown may already be discounted by the markets. Global web searches for the term “recession” has spiked to levels consistent with the COVID Crash and the GFC.
Economic deterioration is attributable to three factors.
- Household consumption has shifted from goods to services. While the shift is not recessionary, it does resulted in a dramatic change in indicators like manufacturing PMI.
- Inflationary pressures from higher prices have resolved in volume destruction, but no demand destruction, which would be recessionary.
- Monetary policy is working to dampen growth expectations.
LinkedIn chief economist Gary Berger
pointed out that the economy may not be as bad as many people feared. While most investors and economists focus on GDP, which is derived from spending data, GDI, which is calculated from income data, is not that bad. Q1 GDI expanded at the trend growth rate of 2%.
Berger’s observation that income-derived data points to continued expansion is consistent with Ben Carlson
‘s conclusion that consumers are prepared for a recession. Household balance sheets are strong and any recession should be mild as leverage is low in the system.
Inflation pressures are easing
Remember the transitory inflation narrative? It’s actually happening. Container freight rates have peaked, which is a signal that supply chain bottlenecks are easing.
The latest release of PCE shows monthly core PCE at 0.3% for May and annual core PCE at 4.7%, both of which were below market expectations. The good news is PCE and core PCE are decelerating on an annual basis. The bad news is the progress in monthly core PCE has been stalled at 0.3% and the base effects of high inflation will dissipate by July. These readings will be encouraging for Fed officials, but they aren’t likely to be convincing enough for a pivot to an easier monetary policy.
Effective monetary policy
The positive effects of tighter monetary policy are appearing. Inflationary expectations are well-anchored and falling. Central bankers will think twice when they consider tighter policy to overshoot their neutral rate targets.
The current cycle looks like a rapid rate hike cycle. The market focus has shifted to whether the Fed will hike 0.50% or 0.75% at the next FOMC meeting to the terminal rate and the timetable for easing policy. Fed funds futures are now expecting a terminal rate of 3.25% to 3.50%, which is down 0.50% from 3.75% to 4.00% after the hot May CPI print. The market expects the Fed to reverse course and ease in mid-2023. In other words, it’s expecting a recession. While this is consistent with the Fed’s SEP projection of a Fed Funds rate of 3.4% at the end of 2022, the Fed expects further tightening in 2023.
Financial markets are inherently forward-looking. If they discount events 6-12 months ahead of time, any recession is already priced in and the stock market’s strength is anticipating a Fed pivot towards easing.
Finally, value signals are appearing in the stock market. Insiders have been buying the dips whenever the market has weakened, which could put a floor on stock prices.
As well, value investor Howard Marks, whose newsletter is admired by Warren Buffett, was profiled in the Financial Times
and said, “Time is ripe to snap up bargains”. He revealed that he is “starting to behave aggressively”.
You ain’t seen nothing yet
Here is the bear case. A global recession is looming. NDR’s Global Recession Probability Model is now at 89.3%. It has never moved above 90% without a global slowdown either being in place or happening soon.
Central bankers are engineering a recession. Even as they focus on fighting inflation, PMI data indicates that they are tightening into a slowdown.
Commodity prices are also signaling a slowdown. Both the liquidity-weighted headline commodity indices, which are heavily weighted in energy, and the equal-weighted indices are breaking down. The all-important copper/gold and base metal/gold ratios are falling, indicating cyclical weakness.
In particular, the copper/gold and base metal/gold ratios have shown a strong history of being a good risk appetite indicator.
More downside risk
If you thought that the market has already fully discounted a slowdown, think again. S&P 500 forward 12-month estimates are just starting to wobble. Historically, EPS falls -17% during recessions. The coming days could see both P/E compression and a falling E.
As an example, Micron’s earnings and Q4 guidance was astonishingly bad. That said, the market reacted positively on Friday to GM’s negative guidance.
also reported that stocks normally don’t bottom until the Fed eases:
If history is any guide, the selloff might still be in its early stages.
Investors have often blamed the Federal Reserve for market routs. It turns out the Fed has often had a hand in market turnarounds, too. Going back to 1950, the S&P 500 has sold off at least 15% on 17 occasions, according to research from Vickie Chang, a global markets strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to bottom out only around the time the Fed shifted toward loosening monetary policy again.
In other words, brace for more downside risk.
Furthermore, don’t bother waiting for Chinese stimulus to pull the global economy out of its slump. The Chinese economy is exhibiting signs of weakness with few signs of recovery. CNBC
reported that China Beige Book found widespread weakness in the wake of the zero-COVID lockdowns.
Chinese businesses ranging from services to manufacturing reported a slowdown in the second quarter from the first, reflecting the prolonged impact of Covid controls.
That’s according to the U.S.-based China Beige Book, which claims to have conducted more than 4,300 interviews in China in late April and the month ended June 15.
“While most high-profile lockdowns were relaxed in May, June data do not show the powerhouse bounce-back most expected,” according to a report released Tuesday. The analysis found few signs that government stimulus was having much of an effect yet.
Sales and profit margins are slumping.
Credit growth is still weak, indicating a lack of stimulus.
reported that Q1 migrant worker wages were flat year on year in real terms, which is a signal of anemic household demand. Other anecdotal evidence points to weakness in both the property market and household sector. If you were waiting for another round of stimulus to boost infrastructure spending, forget it!
A rapid tightening cycle
Here is how I resolve the bull and bear cases. This has been an extraordinarily rapid rate hike cycle. Mary Daly
of the San Francisco Fed pointed out that financial conditions have tightened very quickly compared to past cycles. It is therefore no surprise that the market is discounting Fed easing in 2023.
The economy is in uncharted waters in light of the speed and intensity of the current tightening cycle. Conventional cycle analysis argues for more equity downside in light of the earnings adjustments should a recession materialize. Willie Delwiche
at All Star Charts has proposed a 2008 style template for the stock market.
I think his conclusions are overly alarmist. Even if a recession were to occur, its effects on employment and spending should be relatively mild, like in 1990, when the S&P 500 peak-to-trough drawdown was -20%. The bulls will argue the market has already discounted the downturn and it’s now looking ahead to the easing cycle.
The acid test for market psychology will be Q2 earnings season. How will earnings and guidance come in? More importantly, how will the market react to the news? More immediately, the June Employment Report will serve as another guidepost for the trajectory of monetary policy.